L Pch19

Levy and Post, Investments © Pearson Education Limited 2005

Slide 19.1

Investments

Chapter 19: Futures, Options and other Derivatives


Slide 19.2

Derivatives

• A derivative security is a financial asset that derives its value from another asset.

• A derivate is also known as a ‘contingent claim’, because its value is contingent on characteristics of the underlying security.


Slide 19.3

Use of Derivatives

Investors use derivative contracts in four basic strategies:

1. Hedging.

2. Speculating.

3. Arbitrage.

4. Portfolio diversification.


Slide 19.4

Arbitrage

Arbitrage - arises if an investor can construct a zero investment portfolio with a sure profit.

• Since no investment is required, an investor can create large positions to secure large levels of profit.

• In efficient markets, profitable arbitrage opportunities will quickly disappear.


Slide 19.5

Forward Contracts: I

• An agreement to exchange goods for cash at a pre-specified future date.

• The seller of a forward contract has a short position: an obligation to deliver the goods.

• The buyer of a forward has a long position: an obligation to buy the goods.


Slide 19.6

Forward Contracts: II

Exhibit 19.2 Payoff diagrams for a forward contactSource: From Introduction to Investments, 2nd edn, by Levy. © 1999. Reprinted with permission of South-Western, a division of Thomson Learning: www.thomsonrights.com. Fax 800 730-2215.


Slide 19.7

Swaps

• An agreement between two counterparties to exchange payments based on the value of one asset in exchange for payments based on the value of another asset.

• Four major types of swaps:

1. Interest-rate swaps.2. Credit swaps.3. Currency swaps.4. Commodity swaps.


Slide 19.8

Interest-rate Swap

Counterparties exchange interest payments that depend on pre-specified interest rates:

Exhibit 19.4 Plain vanilla interest-rate swap agreement


Slide 19.9

Credit Swap

Designed to exchange default risk. Two categories of credit swaps:

1. Default swapsOnly default (=credit) risk is exchanged.

2. Total return swapsA combination of an interest-rate swap and a

default swap.


Slide 19.10

Currency and Commodity Swaps

• Currency swapsInvolves the exchange of different currencies, at pre-specified points in time.

• Commodity swapsInvolves the exchange of cash based on the value of a specified commodity, at pre- specified points in time.


Slide 19.11

The Swap Bank

• A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties.

• The swap bank can serve as either a broker or a dealer.

– As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap.

– As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counterparty.


Slide 19.12

An Example of an Interest Rate Swap

• Consider this example of a “plain vanilla” interest rate swap.

• Bank A is a AAA-rated international bank located in the U.K. and wishes to raise $10,000,000 to finance floating-rate Eurodollar loans.

– Bank A is considering issuing 5-year fixed-rate Eurodollar bonds at 10 percent.

– It would make more sense to the bank to issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans.


Slide 19.13


• Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a five-year economic life.

– Firm B is considering issuing 5-year fixed-rate Eurodollar bonds at 11.75 percent (higher risk).

– Alternatively, firm B can raise the money by issuing 5-year floating-rate notes at LIBOR + ½ percent.

– Firm B would prefer to borrow at a fixed rate.


Slide 19.14


The borrowing opportunities of the two firms are:

COMPANY B BANK A

Fixed rate 11.75% 10%

Floating rate LIBOR + .5% LIBOR


Slide 19.15


Bank

A

The swap bank makes this offer to Bank A:

You pay LIBOR – 1/8 % per year on $10 million for 5 years and we will

pay you 10 3/8% on $10 million for 5 years

COMPANY B BANK A



Swap

Bank

LIBOR – 1/8%

10 3/8%


Slide 19.16

COMPANY B BANK A




Here’s what’s in it for Bank A: They can borrow externally at

10% fixed and have a net borrowing position of

-10 3/8 + 10 + (LIBOR – 1/8) =

LIBOR – ½ % which is ½ % better than they can borrow

floating without a swap. 10%

½% of $10,000,000 = $50,000. That’s quite

a cost savings per year for 5 years.

Swap

Bank

LIBOR – 1/8%

10 3/8%

Bank

A


Slide 19.17


Company

B

The swap bank makes this offer to company B: You pay us 10½% per

year on $10 million for 5 years and we

will pay you LIBOR – ¼ % per

year on $10 million for 5 years.

Swap

Bank10 ½%

LIBOR – ¼%

COMPANY B BANK A




Slide 19.18

COMPANY B BANK A




They can borrow externally at

LIBOR + ½ % and have a net

borrowing position of

10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% which is ½% better than they can borrow floating.

LIBOR + ½%

Here’s what’s in it for B:½ % of $10,000,000 = $50,000 that’s quite a

cost savings per year for 5 years.

Swap

Bank

Company

B

10 ½%

LIBOR – ¼%


Slide 19.19


The swap bank makes money too. ¼% of $10 million = $25,000 per year

for 5 years.

LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8

10 ½ - 10 3/8 = 1/8

¼

Swap

Bank

Company

B

10 ½%

LIBOR – ¼%LIBOR – 1/8%

10 3/8%

Bank

A

COMPANY B BANK A




Slide 19.20


Swap

Bank

Company

B

10 ½%

LIBOR – ¼%LIBOR – 1/8%

10 3/8%

Bank

A

B saves ½%A saves ½%

The swap bank makes ¼%

COMPANY B BANK A




Slide 19.21

An Example of a Currency Swap

• Suppose a U.S. MNC wants to finance a £10,000,000 expansion of a British plant.

• They could borrow dollars in the U.S. where they are well known and exchange for dollars for pounds.

– This will give them exchange rate risk: financing a sterling project with dollars.

• They could borrow pounds in the international bond market, but pay a premium since they are not as well known abroad.


Slide 19.22


• If they can find a British MNC with a mirror-image financing need, they may both benefit from a swap.

• If the spot exchange rate is S0($/£) = $1.60/£, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16,000,000.


Slide 19.23


Consider two firms A and B: firm A is a U.S.–based multinational and firm B is a U.K.–based multinational.

Both firms wish to finance a project in each other’s country of the same size. Their borrowing opportunities are given in the table below.

$ £

Company A 8.0% 11.6%

Company B 10.0% 12.0%


Slide 19.24

$9.4%


$ £


Company B 10.0% 12.0%

Firm

B

$8% £12%

Swap

Bank

Firm

A

£11%

$8%

£12%


Slide 19.25


$8% £12%

$ £


Company B 10.0% 12.0%

Firm

B

Swap

Bank

Firm

A

£11%

$8% $9.4%

£12%

A’s net position is to borrow at £11%

A saves £.6%


Slide 19.26


$8% £12%

$ £


Company B 10.0% 12.0%

Firm

B

Swap

Bank

Firm

A

£11%

$8% $9.4%

£12%

B’s net position is to borrow at $9.4%

B saves $.6%


Slide 19.27


$8% £12%Firm

B

The swap bank makes money too:

1.4% of $16 million (= 9.4% - 8%) financed with 1% of £10 million (=11% - 12%) per

year for 5 years.

Swap

Bank

Firm

A

£11%

$8% $9.4%

£12%


Slide 19.28


$8% £12%

$ £


Company B 10.0% 12.0%

Firm

B

The swap bank makes money too:

-1% of £10 million = -£100,000 = -$160,000 per year for 5 years. The swap bank faces

exchange rate risk, but maybe they can lay it off (in another swap).

1.4% of $16 million = $224,000 per year

for 5 years.Swap

Bank

Firm

A

£11%

$8% $9.4%

£12%


Slide 19.29

Futures Contracts

An agreement to exchange goods (or a variable amount of money) for an agreed

amount of cash at some future date, and at a predetermined price or rate.


Slide 19.30

Futures vs. Forward Contracts

• Futures contracts are traded on financial exchanges and have standardized conditions. Forwards are OTC contracts and do not have standardized conditions.

• Futures are marked to market, hence their cash-flow pattern is different from forwards, which are not marked to market.

• Because of this marking to market, futures contracts also have less credit risk than forwards.


Slide 19.31

Options

• An option gives its holder the right to buy or sell a specified amount of an underlying asset at a pre-determined price.

• Two basic types of options:

- Call options (right to buy).- Put options (right to sell).


Slide 19.32

Option Definitions: I

• Strike Price (also Exercise Price)The predetermined price at which the holder of an option has the right to buy or sell the underlying asset.

• Expiration Date (also Maturity Date)The date on which an option expires, or ceases to exist when the option is not exercised.


Slide 19.33

Option Definitions: II

Intrinsic Value

The value of an option if it is exercised immediately, unless this value is negative, in which case the intrinsic value is zero:


Slide 19.34

Payoff Diagrams

Payoff diagrams at expiration can be constructed as follows:

1. Determine the intrinsic value of the option.

2. Add (or subtract) the option premium that has been received (paid).


Slide 19.35

Payoff Diagrams: An Example

Exhibit 19.14 Payoff diagram for buying a put option (long put)


Slide 19.36 Investment Strategies Using Derivatives: I

Simple strategy:

Exhibit 19.19 Payoff diagram: buying a stock and a put option


Slide 19.37 Investment Strategies using Derivatives: II

More complex strategies:

1. Spreads.

2. Straddles.

3. Strangles.


Slide 19.38

Financial Engineering

New, innovative financial instruments based on derivatives principles have become available on the OTC markets since the 1980s and 1990s.

Examples:

1. Exotic options.2. Options on futures and swaps.3. Credit spread options.4. CAT bonds.5. Weather derivatives.

Date post:	08-May-2015
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